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Medical marijuana stocks have been the talk of Canada’s penny-stock universe since the start of April. They have generated a frenzy of excitement among retail investors and encouraged dozens of new entrants to jump into the business. All the key players will be in Toronto this Thursday for the “GreenRush” marijuana investment conference.

The stampede of new firms into this space has astonished longtime industry insiders. They warn it will be very tough for these companies to make money, and very few will be viable in the long term.

Ironically, the market hysteria is a direct response to the federal government’s efforts to rein in the sector. Ottawa introduced new rules — which took effect April 1 — that require patients to buy medical marijuana from licensed producers rather than grow it themselves.

The idea was to improve safety, security and oversight of pot production and distribution. The unintended side effect is that a cottage industry of marijuana stocks has sprung up out of nowhere and recorded parabolic gains.

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They started to emerge just before April 1, and there are now 31 companies on Canadian stock exchanges that claim to be pursuing opportunities in medical marijuana, according to Financial Post data. Prior to this year, there were none. More than a dozen of them are former junior mining companies that were going nowhere and decided a change of strategy was in order.

For example, Matica Graphite Inc. changed its focus three times in less than a year: from copper, to rare earths, to graphite, and finally to marijuana.

Nowhere is the impact being felt more than the Canadian Securities Exchange (CSE). The tiny emerging stock exchange is home to 13 marijuana companies, and they already make up roughly 7% of its total market value.

“Obviously the [marijuana] stocks have been a tremendous contributor to the trades and share volume that we’ve had over the last few months,” said Richard Carleton, chief executive of the CSE.

Some of the short-term stock gains in these stocks are astounding, even though they have come down from their highs. Leading the way is Affinor Growers Inc., which has climbed as much as 3,500% since it announced a move from mining into marijuana in March.

The pot stock frenzy is causing concerns for regulators. Last week, the Canadian Securities Administrators (CSA) warned investors to be cautious. They pointed out that these firms cannot produce pot legally unless they have a license. Health Canada has granted licenses to 13 companies so far, but only one of them (Tweed Marijuana Inc.) is publicly-traded. Another licensed company (Bedrocan Canada Inc.) is in the process of going public through a reverse takeover.

The CSA warning rattled some investors, but a lot of industry insiders thought it was welcome and long overdue.

“There’s only a small handful of real players in the industry,” said Nick Brusatore, Affinor’s chairman.

“The public perception and the way some of these companies are presenting themselves is a little dicey, in my opinion.”

He pointed out that getting a licence to produce pot is a real challenge. And even if you have it, there is the bigger challenge of actually making money.

Marijuana firms described the licensing process as very long and arduous. It involves security checks, quality assurance checks, traceability software checks, and a demonstration of good scientific knowledge. There are also regular queries and investigations by Health Canada after the license is issued, and the license itself has to be renewed every year. Health Canada demanded recalls from two companies this year, and temporarily suspended the license of one of them (Greenleaf Medicinals).

“Health Canada is taking the right approach,” said Marc Wayne, Bedrocan’s CEO. “They spent a week at our facility several weeks ago and were there daily going through everything. It’s very intensive — that’s the way it should be.”

He added that the government’s licensing requirements are becoming even more rigorous as new applications pile in. He believes this is healthy as it should dismantle the stigma that the medical marijuana industry is shady. Health Canada has received close to 900 applications from companies looking for marijuana licenses.

Profitability is another question, particularly for companies entering production for the first time. Investors will be watching Tweed’s upcoming financials carefully, as they will provide the first glimpse of how profitable the sector is. There is speculation that some of the licensed companies are struggling to make money.

This will become the central issue if more of these publicly-traded companies become licensed. There will be stiff cost competition, and investors will flock to whoever can produce it cheapest.

As chaotic as the marijuana stock boom has been in Canada, it is nothing compared to the United States, where there are at least 130 companies claiming to be in the pot business, according to Bloomberg.

The U.S. is a veritable Wild West for investors. Marijuana has been legalized in Colorado and Washington, and is approved for medical use in 21 states. But some states maintain very strict anti-pot laws. Even serious industry players are confused about how to build a business in a country where there is no consistency.

Most pot stocks south of border list on poorly regulated over-the-counter markets. The Marijuana Index, which tracks the performance of 44 U.S. cannabis-related names, is made up mainly of penny stocks.

The inconsistent rules in the U.S. helped open the door to another problem: fraud. Last month, the Securities and Exchange Commission issued a warning about “possible scams” among microcap companies claiming to be in marijuana. It has already suspended trading of several of them.

The SEC’s statement was far more serious than the CSA’s warning in Canada, which expressed concern about irrational stock gains but did not suggest that the companies have done anything illegal. To the credit of Canada’s exchanges, they have halted some of these marijuana stocks to ensure that the companies have a legitimate business plan.

While the CSA’s alert is not great for “optics,” it does shed light on the industry’s darker side, Mr. Wayne said, in particular by highlighting the growing number of companies who remain unlicensed and have little or no previous experience in the field.

It will take a long time for the marijuana industries on both sides of the border to shake themselves out. There will need to be massive consolidation to bring the number of companies down to a more reasonable level and get rid of the dozens of pretenders, experts said.

“The select group of companies that make it through will be market leaders,” Mr. Wayne said. “How many that will be, I can’t tell, but the early entrants have a huge advantage. The main players are already in the game.”

Assuming a viable industry emerges, it appears that Canada may be the better bet for marijuana investments than the U.S. With one clear set of rules coming from Ottawa, Canada offers much greater certainty and consistency for anyone interested in this business.

“We have been asked many times about taking our business south of the border and that is something we are not wanting to do because we are very conscious of tainting our brand,” Mr. Wayne said. “[In Canada] we work under federal regulations, but south of the border it’s a different animal completely.”

In the longer run, there is one big question mark that could throw the entire Canadian industry into chaos: outright legalization. That would drive up supply and could push prices significantly lower. Put simply, pot would resemble a normal commodity.

Mr. Brusatore is a firm believer that legalization is inevitable, and when it arrives, he thinks Big Tobacco is going to contract from the people that can produce it the cheapest. All the rest will be out of business.

“It’s going to fall into the wheelhouse of the farmers — the guys who actually mass-produce plants. Not the growers in the basements that a lot of these guys have come out of,” he said.

In the meantime, even the most aggressive investors know that caution is warranted in this sector. As the CSA suggested, the Potcom Boom could go bust very quickly, and the comedown for investors would not be pleasant.

Active Investor was produced by Postmedia's advertising department in collaboration with iShares by BlackRock to promote awareness of this topic for commercial purposes. Postmedia's editorial departments had no involvement in the creation of this content.

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